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# Differential

Analysis: The Key
to Decision Making
GROU
P1
SANTIAGO, KATHLENN P.
UMALI, CRISHELYN T.
UYANGURIN, JOEVANIE C.

138 Maintenance and repairs 0.380 0. a Boston student. in whole or in part. Two broad categories of costs are never relevant in any decision.036 . She is trying to decide which alternative is less expensive and has gathered the following information: 1 2 3 4 Automobile Costs (based on 10. By car.065 5 Parking fees at school 360 0. Identifying Relevant Costs Cynthia. Unavoidable costs are irrelevant costs. Relevant Costs and Benefits  A relevant cost is a cost that differs between alternatives.  A relevant benefit is a benefit that differs between alternatives. it is 230 miles to her friend’s apartment.000 miles driven per year) Annual Cost of Fixed Cost per Items Mile Annual straight-line depreciation on car P 2. differential costs. She can drive or take the train. or incremental costs) and relevant benefits (also called differential benefits or incremental benefits). Different Costs for Different Purposes Costs that are relevant in one decision situation may not be relevant in another context.800 P 0. A future cost that does not differ between the alternatives. Avoidable costs are relevant costs. Thus. They include: Sunk costs. in each decision situation.Learning Objective 1 Identify relevant and irrelevant costs and benefits in a decision. is considering visiting her friend in New York. Identifying Relevant Costs An avoidable cost is a cost that can be eliminated. the manager must examine the data at hand and isolate the relevant costs. 2 Ignore everything else including sunk costs and future costs and benefits that do not differ between the alternatives.100 Annual cost of auto insurance and license 1.280 Cost of gasoline 0.   Keys to Successful Decision-Making 1 Focus only on relevant costs (also called avoidable costs. by choosing one alternative over another.

hassle of parking in New York. Which costs and benefits are relevant in Cynthia’s decision? The cost of maintenance and repairs is relevant because in the long-run these costs depend upon miles driven. Some of these items can be measured in dollars and some can’t. It will remain the same if she drives or takes the train. such as the reduction in resale value per mile driven. The annual cost of insurance is not relevant. benefits of having a car in New York. Which costs and benefits are relevant in Cynthia’s decision? The decline in resale value is relevant due to the additional miles driven. If she takes the train. At this point. cost of putting her dog in the kennel. .619 per mile are relevant and others are not. Which costs and benefits are relevant in Cynthia’s decision? The cost of the car is a sunk cost and is not relevant to the current decision.619 Some Additional Information 7 Reduction in resale value of car per mile of wear P 0. so it varies depending on the decision.6 Total average cost P 0. round-trip train fare. we can see that some of the average cost of P0. The parking fee at school is irrelevant because it is not a differential cost. the cost would not be incurred. and the per day cost of parking in New York. benefits of relaxing on the train. the cost of gasoline is clearly relevant if she decides to drive. However.026 8 Round-tip train fare P 9 Benefits of relaxing on train trip 1 0 Cost of putting dog in kennel while gone 11 Benefit of having car in New York ???? 1 2 Hassle of parking car in New York ???? 1 3 Per day cost of parking car in New York 104 ???? P 40 P 25 She has also gathered additional information to aid in her decision.

000 units @ P14 per unit) Direct labor (5.000 120.000 62.000 P12.90 Reduction in resale (460 @ P0. The kennel cost is irrelevant because it is not a differential cost.The round-trip train fare is relevant because it is avoidable if she drives her car. but difficult to quantify.026 per mile) 11.000 (3.000 (3.000 units @ P2 per unit) Total variable expenses Contribution margin Less fixed expense: Other Rent on new machine 70. it may be the nonfinancial or nonquantitative factors that have the most impact on our decision.000 per year.96 Parking in New York (2 days @ P25 per day) 50.000 P - - 3.000) 30. Data about the company’s annual sales and costs with and without the new machine are: Less variable expenses: Direct materials (5. Relevant Financial Cost of Driving Gasoline (460 @ P0.000 40.000 .000 105.00 Total and Differential Cost Approaches The management of a company is considering a new labor-saving machine that rents for P3.065 per mile) 29.00 Maintenance (460 @ P0.000 25.000 units @ P8 and P5 per unit) Variable overhead (5. as with any decision we may face.000 - Total fixed expenses Net operating income 70.000) 65.00 Total P 137.000 15.000 10. Relaxing on the train is relevant.000 P 18.100 per mile) P 46.000 15.000 80. Which costs and benefits are relevant in Cynthia’s decision? The cost of parking in New York is relevant because it is avoidable if she takes the train. The benefits of having a car in New York and the problem of finding a parking space are both relevant. but difficult to quantify. Cynthia would be better off taking the train. From a financial standpoint.000 62.000 10.000 62.86 Relevant Financial Cost of Taking the Train Round-trip ticket P 104. But.000 95.

Assume the following information for a company considering a new laborsaving machine that rents for P3. Learning Objective 2 Prepare an analysis showing whether a product line or other business segment should be added or dropped.000 per year. The difference between the two income statements of P12. Due to the declining popularity of digital watches. Lovell Company’s digital watch line has not reported a profit for several years. A Contribution Margin Approach DECISION RULE Lovell should drop the digital watch segment only if its profit would increase. To assess this impact. Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment. it is necessary to carefully analyze the costs. Using the differential cost approach is desirable for two reasons:   First. Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped. only rarely will enough information be available to prepare detailed income statements for both alternatives.000 . Second. Ultimately. mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. Segment Income Statement Digital Watches Sales Less: variable expenses P 500. The total cost approach requires constructing two contribution format income statements – one for each alternative. Lovell is considering discontinuing this product line.000 equals the differential benefits shown at the bottom of the right-hand column.

factory space 70.000 90.000 Rent .000 P 300.000 \$ (40. Should Lovell retain or drop the digital watch segment? Contribution Margin Solution Contribution margin lost if digital watches are dropped Less fixed costs that can be avoided Salary of the line manager \$ 90.000) 260.direct 100. expenses Net operating loss P 120.000 400.000 100.000) .000 70. general not be factory product The equipment used to manufacture digital watches has no resale value or alternative use.000 Net disadvantage Comparative Income Approach \$ (300.Variable manufacturing costs Variable shipping costs Commissions Contribution margin Less: fixed expenses General factory overhead Salary of line manager Depreciation of equipment Advertising .direct Rent .000 75.000 Advertising .factory space General admin.000 50.000 5. The fixed general overhead and general administrative expenses assigned to this would be reallocated to other product lines.000) Also assume that an investigation has revealed that the fixed factory overhead and fixed general administrative expenses will affected by dropping the digital watch line.000 P 60.000 P (100.000 200.000 30.

000 70.factory space General admin.000 5. A decision to carry out one of the activities in the value chain internally.000 100.000) Less variable expenses: segment.000 260.000) Learning objective 3 Prepare a make or buy analysis.000 \$ (40.000 100.000 60.000) 90.000 50. The Make or Buy Analysis When a company is involved in more than one activity in the entire value chain.000 300. The unit product cost of this part is: Direct materials Direct labor P 9 5 .000 400.000 140.000 30.000 70.000 200.000 \$ \$ (500.000) 60.000 \$ (140.000 (300.000 75.000 75. expenses Total fixed expenses Net operating loss 120.000) - 120. it is vertically integrated.000 50.000 5. Manufacturing expenses Shipping Commissions Total variable expenses Contribution margin Less fixed expenses: General factory overhead Salary of line manager Depreciation Advertising . Example Essex Company manufactures part 4A that is used in one of its products.000 200.The Lovell solution can also be obtained by preparing comparative income statements Comparative Income Approach showing Solution results with Drop and without Keep Digital Digital the digital Watches Watches Difference watch Sales \$ 500.000 90.direct Rent . rather than to buy externally from a supplier is called a “make or buy” decision.000 30.000 \$ (100.

Supervisor's salary General factory overhead Unit product cost 1 3 2 10 P 30 • The special equipment used to manufacture part 4A has no resale value. the equipment has no resale value. • An outside supplier has offered to provide the 20. it is also irrelevant to the decision. Notice that the depreciation of special equipment represents a sunk cost.000 100.000 20.000 units) Direct labor Variable overhead Depreciation of equip. Should we accept the supplier’s offer? Cost Per Unit Outside purchase price P 25 Direct materials (20. would be unaffected by this decision.000).000 P 340. Supervisor's salary General factory overhead Total cost \$ 9 5 1 3 2 10 P 30 Cost of 20.000 P 500. The general factory overhead represents future costs that will be incurred regardless of whether Essex makes or buys part 4A.000 180.000). which is allocated on the basis of direct labor-hours. thus the special equipment and its associated depreciation expense are irrelevant to the decision.000 The avoidable costs associated with making part 4A include direct materials (P180.Variable overhead Depreciation of special equip. • The \$30 unit product cost is based on 20.000 40.000). variable overhead (P20.000).000 parts produced each year.000 Units Make Buy P 500. and the supervisor’s salary (P0. hence. Furthermore. • The total amount of general factory overhead. Learning Objective 4 Prepare an analysis showing whether a special order should be accepted. . direct labor (P100.000 parts at a cost of P25 per part.

000 20.000 5.  A foreign distributor offers to purchase 3.000 \$ 12.000 units times \$8 a unit.000 units is as shown.000 40. When analyzing a special order.000 60.000 × \$10) Increase in costs (3. Inc.000 10..000 units.000 × \$8 variable cost) Increase in net income \$ 30.000 by \$6. Inc.000. the incremental revenue of \$30.000 5.000 will exceed the incremental costs of \$24.000 units for \$10 per unit. This suggests that Jet .  Annual capacity is 10.Key Terms and Concepts A special order is a one-time order that is not considered part of the company’s normal ongoing business. is currently producing and selling only 5.000 If Jet accepts the special order. but Jet. Total variable cost would be 5..000 \$20.000 A contribution format income statement for Jet’s normal sales of 5. Increase in revenue (3.000 × \$20) Variable costs: Direct materials Direct labor Manufacturing overhead Marketing costs Total variable costs Contribution margin Fixed costs: Manufacturing overhead Marketing costs Total fixed costs Net operating income \$100. Assume variable cost is \$8 a unit.000 \$ 6.000 48. Since the existing fixed manufacturing overhead costs would not be affected by the order. Should Jet accept the offer? Revenue (5. makes a single product whose normal selling price is \$20 per unit. only the incremental costs and benefits are relevant. Special Orders  Jet.000 \$28.000 24.  This is a one-time order that would not affect the company’s regular business.000 units. they are not relevant.

. The machine or process that is limiting overall output is called the bottleneck – it is the constraint.50 min. • Rather.00 2. total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource.should accept the order. Notice that this answer assumes that the fixed costs are unavoidable and that variable marketing costs must be incurred on the special order. Key Terms and Concepts When a limited resource of some type restricts the company’s ability to satisfy demand. Learning Objective 5 Determine the most profitable use of a constrained resource. The machine or process that is limiting overall output is called the bottleneck – it is the constraint. • A company should not necessarily promote those products that have the highest unit contribution margins.200 30% min. so the product mix that maximizes the company’s total contribution margin should ordinarily be selected. the company is said to have a constraint. 0.000 40% 1. Example Ensign Company produces two products and selected data are shown below: Product Selling price per unit Less variable expenses per unit Contribution margin per unit Current demand per week (units) Contribution margin ratio Processing time required on machine A1 per unit 1 \$ 60 36 \$ 24 2 \$ 50 35 \$ 15 2. Utilization of a Constrained Resource • Fixed costs are usually unaffected in these situations.

Total time required to make Product 2 1.In addition.50 \$ 30 min. × . we could make 1 unit of Product 1. Total time available Time used to make Product 2 Time available for Product 1 2. The key is the contribution margin per unit of the constrained resource.200 0.00 \$ 24 min.400 1. What generates more profit for the company. Ensign should emphasize Product 2 because it generates a contribution margin of \$30 per minute of the constrained resource relative to \$24 per minute for Product 1.100 1. As suggested by the answer to the Quick Check question. Ensign can maximize its contribution margin by first producing Product 2 to meet customer demand and then using any remaining capacity to produce Product 1. Should Ensign focus its efforts on Product 1 or Product 2? How many units of each product can be processed through Machine A1 in one minute?  One unit of Product 1 and two units of Product 2. or 2 units of Product 2. Alloting Our Constrained Resource (Machine A1) Weekly demand for Product 2 Time required per unit 2.50 units min. Product Contribution margin per unit Time required to produce one unit Contribution margin per minute ÷ 1 \$ 24 1.100 min. With one minute of machine A1. with a contribution margin of \$24. using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?  Product 2. and there is excess capacity on all other machines.400 minutes per week. min.300 min. each with a contribution margin of \$15 per unit. assume that Machine A1 is the constraint. Machine A1 has a capacity of 2. ÷ 2 \$ 15 0. min.

According to the plan. Because the additional machine time would be used to make more units of Product 1. Learning Objective 6 Determine the value of obtaining more of the constrained resource.200 units of Product 2 and 1.200 board feet to satisfy its demand. Our contribution margin looks like this. which had a contribution margin per minute of \$24.200 > 2. 2. This mix of production (for example.200 units of product 2 and 1.300 of Product 1. Ensign should be willing to pay up to \$24 per minute. Colonial Heritage makes reproduction colonial furniture from select hardwoods.000 board feet this month. Is this enough hardwood to satisfy demand? Chairs Tables Selling price per unit \$80 \$400 Variable cost per unit \$30 \$200 Board feet per unit 2 10 Monthly demand 600 100  No. How much should Ensign be willing to pay for an additional minute of A1 machine time? The additional machine time would be used to make more units of Product 1. we will produce 2. Value of a Constrained Resource Increasing the capacity of a constrained resource should lead to increased production and sales.000 Colonial Heritage needs 2.200. This amount equals the contribution margin per minute of machine time that would be earned producing more units of Product 1.300 units of product 1) would yield a total contribution margin of \$64. . (2  600) + (10  100 ) = 2. The company’s supplier of hardwood will only be able to supply 2.

Joint Costs • In some industries. What plan would maximize profits?  Production of 600 chairs and 80 tables would maximize contribution margin. . in numerous ways such as: 1. Assume the company follows the plan we have proposed. 6. As before. Subcontracting some of the processing that would be done at the bottleneck. Reducing defective units processed through the bottleneck. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?  The additional wood would be used to make tables. In this use.The company’s supplier of hardwood will only be able to supply 2. which is called relaxing (or elevating) the constraint. Learning Objective 7 Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. 2.000 board feet this month. a number of end products are produced from a single raw material input. Focusing business process improvement efforts on the bottleneck. each board foot of additional wood will allow the company to earn an additional \$20 of contribution margin and profit. 4. Managing Constraints It is often possible for a manager to increase the capacity of a bottleneck. Shifting workers from non-bottleneck processes to the bottleneck. 5. Working overtime on the bottleneck. Investing in additional machines at the bottleneck. 3.000 board feet this month. Colonial Heritage’s supplier of hardwood will only be able to supply 2.

these costs should not be allocated to end products for decision-making purposes. For example. in the petroleum refining industry a large number of products are extracted from crude oil. Inc. EXAMPLE • Sawmill. lubricants. • Unfinished lumber is sold “as is” or processed further into finished lumber. asphalt. • Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs. home heating oil.. jet fuel. Joint costs are common costs incurred to simultaneously produce a variety of end products. cuts logs from which unfinished lumber and sawdust are the immediate joint products. With respect to sell or process further decisions. including gasoline. and various organic chemicals. Therefore. The term joint cost is used to describe costs incurred up to the split-off point. • The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point. it is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point.” Analysis forSell or Process Further Per Log Lumber Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing P 270 140 130 50 Sawdust P 50 40 10 20 .• Two or more products produced from a common input are called joint products. Sell or Process Further Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward.

Profit (loss) from further processing P80 P(10) The lumber should be processed further and the sawdust should be sold at the split-off point. .